Commodities provide an appealing investment class for conscientious investors that are interested in diversifying their portfolio. Unlike equities, bonds, and currencies, commodities do not run the risk of default as they have intrinsic value. Gold, for example, is one of the most ancient and reliable store houses of value known to humankind. Furthermore, commodity prices exhibit one of the hallmarks of investor diversification as changes in their prices may counteract changes in the value of other asset classes. As such, commodities may be considered a safe haven investment, means of diversifying an investment portfolio, and hedge against inflation.
The key drawback to commodities as an investment is the fact that their physical nature makes them somewhat incompatible with the speed and interconnectivity of the modern financial system. As a result, a common substitute for direct investment in a commodity was to invest in equities associated with producers of that commodity. For example, an investor interested in investing in gold would invest in gold mining companies. However, this solution partly defeats the purpose of investing in commodities in the first place because an investor is then exposed to an array of other risks, including the risk of the producers defaulting; as such, the use of the investment as a diversifier is thereby somewhat mitigated. Institutional investors have also been able to invest in commodities through access to more complex financial products, including financial derivatives, such as futures; however, these financial products have not been traditionally available to retail investors. Ordinary retail investors have historically been prevented from investing directly in commodities.
Recently, financial products that allow retail investors to invest in gold directly have become more readily available through the use of securitized pools of gold. Through securitization, the value of a commodity can be disassociated with the physical nature of the commodity. Shares of a pool of the commodity can be traded so that a transfer of the shares is the legal equivalent of the transfer of a physical portion of that common pool from one party to another. These financial products, such as the Merk Gold Trust, show significant promise for enabling the retail investors of the world to invest in commodities as a pure asset class—wholly distinct from equities and bonds. However, financial products in this class can exhibit significant drawbacks that prevent them from reaching their full potential.
The financial products at issue have at least three main drawbacks. First, they are plagued by the fact that taking delivery of a commodity is prohibitively expensive and is in some cases completely impossible. This is not a trivial problem. If a user is not able to take possession of the commodity in the pool, their ownership of the commodity may be considered a legal fiction. No matter how strongly that fiction may be enforced, it is not true money-in-the-hand ownership. Second, the investment vehicles holding commodities generally store commodities using a format that is incompatible with how a retail investor would prefer to hold the commodity. Taking gold as an example, the commodity here is stored in the institutional system in the form of London Good Delivery Bars which are irregular in terms of both size and purity. It is therefore difficult for a retail investor to serve as an adequate custodian of these bars, and the liquidity of the bars drops precipitously when they are removed from the institutional system. When the bars are input into the institutional system, their weight and purity is determined and guaranteed, and that guarantee attaches to the bar as it is transferred from one institution to the next; the industry refers to this as the “Chain of Integrity”. The same is not true for individual investors, which is why standardized coins or bars are preferred. Third, without the ability to take delivery of the gold, retail investors may never be convinced that the pools they are investing in actually have the commodity they say they do. To the extent large institutions can take delivery of gold, custodians of pools of commodity usually only deliver the commodity “unallocated” which means that ownership is not assigned to a specific physical unit, raising questions as to whether stake holders in the administration of investment vehicles holding commodities are keeping adequate track of the perceived and actual amount of the commodity in the pool. Not only that, but unallocated commodities again have counterparty risk, as they represent a claim against the institution holding the commodity, not an ownership of the commodity itself; the institution might, in turn, lease out the commodity, which is why unallocated gold, for example, is also referred to as “paper gold”, as well as have numerous institution-specific liabilities. In the case of gold, only gold held on a segregated, “allocated” basis is an ownership claim of a specific gold bar. Such pools might have their commodity holdings audited; but without the ability to take delivery of the commodity, such audits do not necessarily alleviate the concern of investors that the commodity is indeed held by the pool.